Understanding Tax Terms: Unearned Income

If the tax code was simple, it wouldn’t matter one bit whether your income was earned income or unearned income. But this isn’t the case. Here are some things to consider:

• Different tax rates.
  While most earned income is subject to ordinary income tax rates up to 37%, unearned income can be subject to different tax rates. Long term capital gains and certain dividends, for instance, are generally subject to lower capital gains tax rates. These tax rates can max out at 20% before a potential net investment income tax of 3.8% is applied.
• Kiddie tax rules.
  The tax code limits the amount of unearned income that can be taxed at your dependent’s (usually lower) income tax rate. Amounts over this limit are taxed at the parent’s rate. The amount is $2,500 in 2023.
• Tax benefit limits.
  Many tax credits and deductions will limit the amount of unearned income you may have and still qualify for a tax break. As an example, the Earned Income Tax Credit limits disqualified (unearned) income to $11,000 in 2023.
• Timing matters.
  Sometimes the timing of an event can shift unearned income from ordinary income tax rates to preferential gain tax rates. This is the case with investment sales. Hold an investment for one year or less before selling it and your unearned investment gain is taxed as ordinary income. Hold it longer than one year and the unearned income is taxed at capital gains tax rates.

It’s important to understand how all elements of income apply to different aspects of the tax code. This is where working with someone familiar with the code can help.